There are various forms of speculating that are common economic activities. Trading and hedging are typically facilitated through financial markets, such as stocks, options, commodities, futures, derivatives, or insurance contracts. Wagering is typically facilitated through gambling markets, such as typical Las Vegas style sports wagering, conventional pari-mutuel betting at horse races, dog races, and jai alai games, political stock markets, or event-based futures markets (e.g., TradeSports.com). Even non-participating persons can benefit from the existence of such markets, since the going prices provide accurate forecasts of the likelihood of future outcomes. See, for example, the political stock markets known as Iowa Electronic Markets, and available at Web site http://www.biz.uiowa.edu/iem/, for instruments derived from political events.
In conventional pari-mutuel gambling, people place bets on which of two or more outcomes will occur at some time in the future. For simplicity, suppose there are two outcomes being wagered on: either a horse named “Alice” will win a race, or a horse named “Bob” will win. People bet money on one horse or the other. Suppose $800 is bet on Alice and $200 on Bob. Now suppose that Alice wins the race. The people who wagered on Bob lose their money ($200 in total). The people who bet on Alice win; these bettors receive all of their initial investment back, plus receive a portion of the money bet on Bob, in proportion to the amount they bet. In other words, every $1 bet on Alice entitles its owner to receive the initial $1 back, plus 1/800 of the $200 bet on Bob—so a $1 bet on Alice returns 1+200/800 dollars, or $1.25. In general, if there are n different outcomes (e.g., horses), and M1, M2, . . . , Mn dollars are bet on each outcome, and outcome i occurs, then everyone who bet on outcomes other than i loses, while every $1 bet on i receives the initial $1 back, plus 1/Mi of the total amount not wagered on i (M1+M2+ . . . +Mi−1+Mi+1+ . . . +Mn). In practice, there is one additional complication. At a real racetrack, the owners of the track first take a certain percent of the total amount wagered, and then redistribute whatever money is left to the winning bettors in proportion to the amount they bet.
Every bet in a conventional pari-mutuel market has an equal payoff. It doesn't matter if the bet is the first bet on the outcome or the last. It doesn't matter how much money has been wagered so far on the outcome at the time the bet is placed. All that matters is the final amount bet on all the outcomes when the market is closed. So really there is no incentive to bet early: it is better to wait until the last minute, in case any new information is revealed, and to get the best idea of what the payouts will be. This is in contrast to environments such as a stock market, where incentives exist to invest any time information changes or new information is revealed, and investing in a stock before everyone else does, when the price is lower, yields a better payout than investing after everyone else, when the price is higher.
A stock market typically operates as a continuous double auction (CDA). A continuous double auction (CDA) constantly matches orders to buy an asset with orders to sell. If at any time one party is willing to buy one unit of the asset at a bid price of pbid, while another party is willing to sell one unit of the asset at an ask price of pask, and pbid is greater than or equal to pask, then the two parties transact (at some price between pbid and pask). If the highest bid price is less than the lowest ask price, then no transactions occur. In a CDA, the bid and ask prices rapidly change as new information arrives, and traders reassess the value of the asset. Since the auctioneer only matches willing bidders, the auctioneer takes on no risk. However, buyers can only buy as many shares as sellers are willing to sell; for any transaction to occur, there must be a counterparty on the other side willing to accept the trade.
When few traders participate in a CDA, it may become illiquid, meaning that not much trading activity occurs. The spread between the highest bid price and the lowest ask price may be very large, discouraging trading. One way to induce liquidity is to provide a market maker who is willing to accept a large number of buy and sell orders at particular prices. Conceptually, the market maker is just like any other trader, but typically is willing to accept a much larger volume of trades. The market maker may be a person, or may be an automated algorithm. Adding a market maker increases liquidity, but exposes the market maker to risk. Depending on what happens in the future, the market maker may lose considerable amounts of money.
In a conventional pari-mutuel market, anyone can place a wager of any amount at any time—there is in a sense infinite liquidity. Moreover, since money is only redistributed among traders/bettors, the market institution itself takes on no risk. The main drawback of a conventional pari-mutuel market is that it is useful only for capturing the value of an uncertain asset at some instant in time. It is ill suited for situations where information arrives over time, continuously updating the estimated value of the asset—situations common in almost all trading and wagering scenarios. There is no notion of “buying low and selling high”, as occurs in a CDA, where buying when few others are buying (and the price is low) is rewarded more than buying when many others are buying (and the price is high). Perhaps for this reason, in most dynamic environments financial markets operating according to the CDA model, which can react in real-time to changing information, are more typically employed to facilitate trading and hedging.
Another conventional market model is the typical Las Vegas bookmaker or oddsmaker. In this case, the market institution (the “book” or “house”) sets the odds, initially according to expert opinion, and later in response to the relative level of betting on the various outcomes. Whenever a wager is placed, the odds or terms for that bet are fixed at the time of the bet. While odds may change in response to changing information, any bets made at previously set odds remain in effect according to the odds at the time of the bet. This market is similar to the CDA with market maker model. The bookmaker accepts nearly all bets at any time at the current odds, though the bookmaker may change the odds in response to new information or relative betting volume. Like a market maker, the bookmaker exposes itself to risk. Depending what wagers were made at what odds, and depending on the outcome of the event being wagered on, the bookmaker may actually lose a considerable amount of money.
U.S. Pat. No. 5,687,968 discusses the problems associated with conventional pari-mutuel wagering and the bookmaker model. It suggests, instead of a single central market, a plurality of individual pari-mutuel markets with respective time periods ending at a different instant in time and fixing the odds after time period of each individual pari-mutuel market has ended. Bets made at the closing of each time period are paid at the odds of that period (and not the final odds). See FIG. 1. But this would have the disadvantage that it would thin out trading in each individual market, and would require a more complicated infrastructure than a single central market. Also, in each individual pari-mutuel market, the incentives would be to wait to bet until just before the ending time of that particular market. One possible way to alleviate this problem would be to have many individual pari-mutuel markets, and to institute a random stopping rule for each individual pari-mutuel market.
Robin Hanson, “Combinatorial information market design”, Information Systems Frontiers, 5(1), 2002, describes a market mechanism called a market scoring rule. The mechanism maintains a probability distribution over all possible future outcomes. At any time, any trader who believes the probabilities are wrong can change any part of the distribution by accepting a lottery ticket that pays off according to a scoring rule (e.g., the logarithmic scoring rule described in Robert L. Winkler and Allan H. Murphy, “Good probability assessors”, Journal of Applied Meteorology”, 7: 751-758, 1968), as long as that trader also agrees to pay off the most recent person to change the distribution. The market interface can be made to look to traders like a continuous double auction with a market maker who is always willing to accept a bid on any outcome at some price. Since the market essentially always has a complete set of posted prices for all possible outcomes, the mechanism avoids the problem of thin or illiquid markets. However, the mechanism requires a patron to pay off the final person to change the distribution. It involves risk on the part of the market maker or patron, although the patron's payment is bounded. Hanson's method is not pari-mutuel in nature, meaning that payoffs are not necessarily redistributive and the amount of money won is not necessarily balanced by the amount lost.